Companies need financing to raise capital for their business. To do so, they have two major options. The first is called equity financing, and the second is debt financing. What do these two terms mean? Which of these financing types will be suitable for your business and why? What are the differences between the two? What are the advantages (and disadvantages) associated with each type?
In this article, we will be answering all of these questions and more. We will look at both types of financing in detail in the following paragraphs. Stay tuned!
Equity Financing vs Debt Financing: An Overview
In simple words, equity financing – as the name suggests – is raising capital by selling equity or a portion of equity. On the other hand, debt financing involves borrowing money from a third party such as a bank or any other financial institution to raise capital for business.
Both of these types have their own set of advantages and disadvantages. The primary benefit of equity financing is that a company is not obliged to repay. It offers extra capital for business growth. But, its disadvantage is that the company has to give up a portion of its ownership. Conversely, the main benefit of debt financing is that a company doesn’t have to give up a portion of their own as they are lending money from another source. Its disadvantage being repayment problems if cash flows decline.
Most companies today use both equities as well as debt financing. But, the choice between these types comes down to accessibility, cash flows, and company ownership. That is, which type is easily accessible, what’s the situation of the company’s cash flows, and how important is the company ownership for its principal owners. Creditors use the debt to equity ratio to judge the ratio between the two for the company’s finances and look positively upon a low debt to equity ratio.
In equity financing, a part of the company’s equity is sold to raise capital. For instance, consider you are the owner of ABC company and want to sell 15% of the ownership to an investor for capital. Now, you don’t have any obligation to repay this money on a monthly basis, so there is no additional financial burden. Besides, you get more funds to grow your business.
However, going forward, the investor holds sway in all business decisions. Now you have to share the profits with the new investor and consult them on every business decision. Their involvement in decision-making depends on the percentage of equity they hold. You can remove an investor by buying them out, but it could be even more expensive.
In debt financing, you borrow money and have to pay it back after some time, along with interest. The main benefit of debt financing is that the lender holds no control over your business decisions. After you have repaid all the loans, your relationship ends. As loan repayments don’t fluctuate, you can easily map out expenses and budgets in advance.
But, debt is an expense. In case of failure to pay it back on schedule or your company fails to grow as expected, it could put your business growth in jeopardy. What’s more, debt financing sometimes puts restrictions on the activities of a company. This can prevent your company from taking advantage of certain opportunities. You also need a low debt to equity ratio if you want to secure some additional debt financing in the future.
Learn about the Pros and Cons of Each
We talked briefly about the advantages and disadvantages of both types briefly above. Let’s look at their pros and cons in more detail now. A better understanding of the pros and cons can help you decide which type of financing would suit your business.
Pros and Cons of Debt Financing
- Doesn’t dilute your ownership of the business – You remain a 100 percent owner of the share, as you were before.
- The lender has no claim over your future profits – Your profits remain your profits. You don’t have to share them with the lender.
- Debt obligations are predictable – You know the timeframe of repayments, so you can plan your business finances ahead.
- Flexible repayment and collateral options – You can put your negotiation prowess to the test and get flexible collateral and repayment options from the lender.
- Interest is tax deductable – So, you can claim to reduce taxable income.
- Debt has to be repaid – It’s an expense after all. You have to pay it back in the future.
- Has qualifying criteria – This can be difficult for some businesses if their credit score or debt to equity ratio is low.
- Can limit your alternative financing options – Some lenders put a restriction on your business to pursue alternative options.
- Comes with financial risks – A higher debt to equity ratio can put your company in jeopardy.
- May require personal guarantee – You – as a business owner – may be required to provide a personal guarantee to pay back the amount.
- Has a risk of default – If you default, your assets could be seized by the lender.
Pros and Cons of Equity Financing
- No dividends – Sure, you may have to share the profits, but there’s no obligation for you to pay dividends on equity.
- Industry experience – A right investor brings in industry connections and business experience, which can benefit your business in the long run.
- No money return – In case the business fails, you don’t have to return the investor’s money.
- No monthly repayments – You don’t have to adjust your budget and finances, keeping the regular loan repayments in mind.
- Extra Capital – You raise extra capital, which you can use for business growth as you please.
- Give up ownership – You are basically selling a portion of your business, so you have to give up ownership
- It costs more – Equity costs more. Investors expect a return on their money. So, you must be willing to share profit. Investors expect more because they are risking more than debt. So, the amount paid to partners can sometimes be more than the interest rate on debt financing.
- Getting Investors can be hard – Money lenders are easy to convince. In contrast, attracting investors can be highly challenging.
- Conflict potential – Investors have a say in your business decisions. Depending on how much equity they hold in your business, investors need to be consulted on every decision. Their decisions may not align with yours.
Why is too much equity expensive?
People often ask, why is debt cheaper than equity? The answer is really simple. It is so because an investor is taking more risk while purchasing a stock than a bond. That’s why they demand a higher return to compensate for the higher risk. Stocks are riskier to invest in as compared to bonds for several reasons. Such as:
- The stock market is highly volatile
- In case of a company defaults, stakeholders have a lower claim
- Capital gains on the investment are never a guarantee
- Dividends are discretionary. The company is not legally obliged to pay dividends.
Therefore, equity financing leads to a higher weighted average cost of capital (or WACC).
Why is too much debt expensive?
At times, too much debt can also be expensive. When you have accumulated too much debt, the cost of debt will rise. That’s because the loan interest rate increases in such a scenario. It is the biggest factor that influences the cost of debt. It also increases the probability of defaulting because more debt means higher interest payments. If a business fails to grow as expected and cannot generate enough cash flows, it will default. So investors demand higher returns from the company that has a higher debt to equity ratio. It then manifests in the form of higher interest rate demands.
Debt or Equity Financing
Choosing between debt or equity financing can be a difficult decision. What works for a company (and business) may not work for yours. So, before deciding on a financing option for your business, ask yourself these questions.
1. How fast do you need cash?
Quick or slow? You can save a lot of time by going with debt financing. It usually takes only a few days. Then there’s financing for the short term or long term. The short term is a revolving debt. You can use it for material costs, etc. Long-term debt financing, on the other hand, comes in the form of installments. Businesses use it to finance their startup or machinery costs. The terms & conditions in debt financing are straightforward. That’s why it takes less time.
Equity financing takes longer. Investors and owners go back and forth discussing & negotiating the package. Much of the time is spent working out the percentage stake and future value of the business. If there is more than one investor, then their differing opinions can further prolong the process. Besides, there are a lot of legal formalities associated with equity financing, which make it a rather time-consuming process.
2. Do you want to keep complete control over your business?
Yes or No? If you choose yes, debt financing is suitable for you. With debt financing, you maintain total control over your company. Lenders don’t have any stakes in your business. They just need the guarantee that you can repay the loan when the time comes.
In equity financing, you lose control over a portion of your business. Depending on the negotiations and how many shares you sell, the investor(s) can end up owning a major percentage of your business and even vote you out. Additionally, you also give up the future.
3. Do you really qualify for the type and amount of financing you need?
Do you? A lender will look at your capacity to repay the loans along with interest. So, they will examine your business’s financial health. They do so by looking at the five Cs of credit. These are:
- The character of the owner
- Credit Rating of the owner
- The capacity of the business
- The collateral that you can pledge
- Conditions of the industry/economy, etc.
Investors will want to know your track record as an entrepreneur. If you have successfully started and run businesses in the past, they will be more than willing to invest. They will also want to know any plan for success in the future. They will look at your business’s long-term viability rather than looking at short-term cash flows.
This brings us to the end of the discussion. We hope now you have a much clear understanding of the difference between debt and equity financing. Both of these financing types have their advantages and disadvantages. Weigh them cautiously before settling on a particular mode of financing for your business. Usually, businesses use equity financing for their large capital needs that aren’t so urgent. Debt financing, on the other hand, is ideal for smaller and urgent capital needs. Other companies go with a combination of both equity and debt financing to minimize their risks. Whichever path you choose, we wish you all the best. Have a great day!